Understanding the VIX: Discover this key measure of market volatility.

Key Takeaways

• The VIX is an index that quantifies anticipated volatility in the stock market for the upcoming 30 days.

• Calculated by the Chicago Board Options Exchange, the VIX assesses the variance in options trades of the S&P 500®.

• The VIX serves as a tool for traders and individual investors to evaluate short-term market sentiment.

  
  

While it is impossible to predict the stock market with absolute certainty, certain indices can help investors evaluate anticipated risks. The Cboe Volatility Index (VIX) is one such tool. It offers an indication of potential future volatility, reflecting expected fluctuations in the US stock market over the forthcoming 30 days. Explore how the VIX operates, the methodology behind its calculation, and the implications of a high or low VIX for your investment portfolio.

What is the Cboe Volatility Index (VIX)?

The Cboe Volatility Index, commonly known as the “VIX,” measures the anticipated 30-day volatility of the US stock market, indicating the expected magnitude and speed of changes in stock prices. Often referred to as “the fear gauge,” higher volatility is associated with increased investor uncertainty. The VIX is the ticker symbol for this index, which was developed by the Chicago Board Options Exchange (Cboe, pronounced see-boh), a trading exchange similar to the New York Stock Exchange, focusing on options contracts.

How does the VIX work?

The VIX assesses market expectations for volatility over the next 30 days based on the bid and ask prices of S&P 500 index options, known as SPX options.

Options are contracts that allow investors to buy or sell a specific security at a predetermined price until a certain date, effectively serving as a bet on the anticipated direction of an investment's price movement. Cboe utilizes real-time data from options prices and quotes on its exchange to create a measure of the expected movement of the S&P 500’s price in the near term.

Generally, a higher VIX, resulting from increased demand and prices for options, indicates less certainty among investors regarding future US stock market prices over the next 30 days. Conversely, a lower VIX, due to reduced options demand and prices, suggests greater investor confidence in future market prices. The VIX typically has an inverse relationship with the S&P 500’s price. Often, when the stock market declines, the VIX rises. However, the VIX is designed to measure short-term volatility rather than consistently move in opposition to stock prices.

How is the VIX used?

The VIX is a valuable tool for investors seeking to understand anticipated price fluctuations in the stock market over the next 30 days. One application is identifying trend reversals; for example, a decline in the VIX from recent highs may suggest a less volatile S&P 500 in the near future.

Investors may utilize the VIX in various ways, including:

• Gauging market sentiment: A particularly high or low VIX can provide insights into other investors' intentions, potentially influencing an investor’s own decisions regarding investment and asset allocation.

• Managing risk: A sharp increase in the VIX, indicating expected future market volatility, might prompt traders to adjust their portfolios towards more conservative investments.

• Hedging: Some traders use VIX-related securities to hedge their portfolios during volatile periods, potentially offsetting losses in other investments.

• Identifying buying opportunities: An increase in the VIX may signal upcoming price swings, suggesting potential buying opportunities for forward-looking securities, such as options, and aiding traders in selecting appropriate trade durations.

How is the VIX calculated?

The Cboe employs a sophisticated calculation to determine the VIX, which fluctuates in real-time throughout the trading day akin to stock and index prices. This calculation considers the real-time average prices between the bid and ask for options with different future expiration dates. Essentially, the VIX is derived as the square root of the expected price changes in the S&P 500 over the next 30 days.

What is a normal value of the VIX?

Historically, the Federal Reserve of St. Louis has reported an average VIX value of approximately 20 from February 2002 to March 2025. However, the precise normal value of the VIX is subject to debate and is influenced by prolonged domestic and international economic pressures. The VIX's level can vary based on market conditions, making it challenging to define a "normal" value.

What is a low value of the VIX?

According to data from the Federal Reserve of St. Louis, a VIX value below 20 is generally considered low, indicating that investors do not expect significant future price swings. However, whether the VIX is perceived as low is relative and depends on recent trends. If the VIX is lower compared to recent levels, it may be deemed low for that specific period.

What is a high value of the VIX?

A VIX value exceeding 20 may be regarded as high, though it can rise significantly higher. During periods of substantial uncertainty, such as the 2008 financial crisis and the onset of the COVID-19 pandemic in 2020, the VIX reached end-of-month peaks in the 50s, as reported by the Federal Reserve of St. Louis. Such elevated values suggest that investors anticipate increased market volatility in the near future.

What to do when the VIX is high

When the VIX is elevated, it is crucial to adhere to your investing or trading plan. Volatility is an inherent aspect of investing, and it is generally advisable not to react impulsively to price fluctuations, particularly for long-term investors. Your investment or trading plan serves as a guide for making informed decisions, regardless of market conditions.

How do you trade the VIX?

While direct investment in the VIX is not possible, trading can be conducted through various investment products such as exchange-traded funds (ETFs), exchange-traded notes (ETNs), and options linked to the VIX. Trading the VIX using these securities may serve as a hedging strategy, but like all investments, it involves risk, including potential volatility in the VIX's value. These advanced strategies should be considered only by experienced traders.

Best Regards,

Stock Market Charlie aka The Hound of 317